A Theory of the Recession

Steve Randy Waldamn has an interesting post on negative rates of return. Krugman relates it to China which brings me around to an idea that I am cooking up.

The Great Recession and likely both the Great Depression and the Long Depression were caused by globalization or international integration on a smaller scale.

I know this suggestion will seem irksome to many of my readers because the Great Recession seems like a thing that is bad and Globalization seems like a thing that is good. I can only say that things of themselves are not bad or good they just are. Our question is, what is?

So, there are two anchors on the real interest rate. One, anchor is the marginal return on capital. That is, if you give up consumption today, how much consumption can you get tomorrow.

The second anchor is the discounted ratio of marginal utility of consumption across time. That is, how much happier will you be tomorrow if you give up a dollar today.

Everything else being equal giving up a dollar today is more bad than getting a dollar tomorrow is good, because people put less value on the future. So without any sort of inducement people wouldn’t naturally save.

The inducement to save comes from the real interest rate. As long as the real interest rate is positive refraining from consuming a dollar’s worth of stuff today will give you more than a dollar’s worth in the future.

A second wrinkle is added, however, by the fact that a positive interest rate means that if society as a whole saves society as a whole will be richer tomorrow and hence an extra dollar’s worth of consumption will be worth less than it otherwise would

Fortunately there typically exists a balance between all these forces which has us saving, investing and consuming more over time. The real interest rate remains positive and society moves towards what economists call the steady-state.

That’s all fine and its standard growth theory. Here is the wrinkle.

An additional factor that has to be considered is technological change. As technology improves society will be wealthier in the future even if it doesn’t save and invest.

This is because when economists speak of technology we know-how. As our understanding of the world improves we can do more with less and so we are fundamentally wealthier, even if we don’t have more buildings or machines. – the kind of stuff with think of as investment.

Now here is where globalization fits in.

Globalization offers US firms an increase in productivity from offshoring. This increase in productivity operates in many ways like an increase in technological growth. We can now do more with less because we can trade with others who have a comparative advantage in certain areas.

Now imagine that we are on some steady state path. We are cruising along, saving, investing and becoming wealthier.

The suddenly barriers to trade collapse. The communist bloc falls. China opens up etc. This causes a rise in the rate of the rate of technological growth.

As long as the rise isn’t to fast nothing all that special happens. The rate of savings in the US simply slows as American citizens use gains from trade rather than investment to increase living standards over time.

However, if the gains from trade are extremely large then it can shift us to a new paradigm where the model demands a negative savings rate. Our future selves are so rich in the bounty of international trade that wealth maximization requires us to borrow from them to fuel consumption now.

In industrial production this is actually not that hard to facilitate. Obsolesce comes quickly to industrial machinery. All you have to do is stop upgrading American equipment, wait until it runs out and then ship the jobs overseas.

Letting your equipment fall apart is akin to negative savings. And, the whole thing makes sense because the United States is effectively over-industrialized relative to its trading partners. Letting machines wear out here and rebuilding them there is the wealth maximizing thing to do.

The story is different when in comes to structures like houses and shopping centers. There is effectively no way to ship them overseas yet still receive the service stream from them.

What you can do, however, is extract value from them via the bond market. You take out mortgages on the structures, sell those mortgages to the Chinese and use that to fuel consumption right now. This again is the wealth maximizing thing to do, because you want to shift consumption from the future to today.

The problem is that forms is two fold.

First, this process is facilitated by a fall in the real interest rate, which allows heavy borrowing against by both raising the value of the asset and easing the financing costs. Yet, if the gains from trade are growing fast enough they will drive the real interest rate to zero, at which point land prices become undefined.

Because land does not depreciate you are taking the present discounted value of land but applying a discount factor of zero. This means every piece of land is worth an infinite amount.

Second, this creates a time inconsistency problem. It is in your interest to borrow heavily now under the conditions that you will repay the loan. However, because real interest rates are zero collateral values do not rise over time. Hence, any fluctuation in the value of collateral simply from trembling hand forces will make it worth your while to default.

If everyone is aware of the second factor then this will bind land values away from infinity because no one will be able to borrow ever greater amounts of money to purchase land. However, there is no inherent stability, guess wrong and there will be a wave of optimum defaults.

I think this type of model could explain the run-up in land prices during the 2000s. We would need to combine this with some balance sheet model of spending to then show how the collapse could force the economy into a liquidity trap.

[…] lead, the critical question is – how long can th […] Jon-Paul Modeled Behavior FeedA Theory of the Recession November 8, 2011Steve Randy Waldamn has an interesting post on negative rates of return. Krugman […]

what is the role of uncertainty that situations can change in this picture? If land values go to infinity, then uncertainties on that should also become very large. Is that your ‘trembling hand’ force?

Very much so. Mortgage rates fell to the rate of rent growth in metro areas leading to undefined valuations. As high as they went, they became unstable, both with respect to changes in interest rates and fluctuations in growth rates. The normal lending limitation of debt service against current income was waived until growth failed when it ran out of new pyramid entrants.

If people have the expectation that productivity will drive future output up to such a level that a smaller amount of saving will buy more stuff in real terms wouldn’t that drive the rate of interest up rather than down as there will be smaller pool of savings to finance current investment ?

More or less true, but all land will be destroyed in a supernova eventually. There are many other less drastic events that could reduce the value of any particular acre of land. For example, having it be under the sea. or located in a rift, or something.

Then there is political risk. What if it is nationalized without compensation 300 years from now?

Suppose the 1.5 children per couple keeps up and population falls. Perhaps very little land will be needed after a time.

Permanetly zero (much less negative) real interest rates creates paradoxes for land that will have some value forever. But forever isn’t possible–the supernova.

Hang on. If technological change is like a windfall, then faster technological change should increase the real interest rate. If everyone expects to win the lottery next year, they want to consume more today, which reduces desired saving, which increases the equilibrium rate of interest.

So if I understand properly this theory would rely on a global factor productivity positive shock leading to ‘over-consumption’ as consumer preference for present consumption is sticky (or exogenous). If productivity shock leads to lower investment appetite for a given real interest rate, which translates into lower rates and lower investment/savings.
Many questions around this comes to (my uneducated) mind, many of which might look pointless: so sorry for the noise if it’s the case.
Is it another way to model capitalism instability and long run cycles: the succession of equilibrium can lead to divergence due to some relative stickiness of preferences vs. productivity?
If this is accurate, one should have witnessed a down trend in Investment rate/capital accumulation going along the downtrend in real rates: was it the case in the us economy ?
Does such a framework apply to the tech bubble as well, when people were anticipating a global factor productivity shock as well (or was it China already)?
During the great depression the US was today’s China: the new major industrial player in the globalization. Even if trades was not as liberalized as it is today, can such mechanism be symmetric in its effect on trade partners ? (over-consumption in China looks unlikely but there’s lots of talks about real estate bubble there).
Developped economy increase in leverage started far earlier than in the late 90’s, and coincided with interest rates getting lower since the 70’s. May be it would be interesting to apply your framework to the whole sequence from gret depression/war / post-war until Europe slow down in the 70’s / 8à’s to 90’s / and then China and the 2000’s development.To see what part the framework properly graps in the full deleveraging/leveraging cycle ?

@Nick Rowe
I agree with you that a windfall, ceteris paribus, should raise the rate of interest, but here Karl doesn’t spell out exactly what happens to investment: Perhaps ex-ante investment also becomes negative, but more strongly even than savings, as anyone involved in repair of any sort is off to celebrate the arrival of glorious globalization (infrastructure decay in the US comes to mind)? Thus, even though no one wants to save anything, because tomorrow will be heavenly anyway, they can cover their dissaving by “dis-investing” (=making machines into bicycles?) and any pocket change they want to keep in the bank, just in case, they need to pay negative interest rates on because the bank has no one to give a loan to.
Any better story would be appreciated (or clarification on how the negative interest rate comes about)

Short term, a lot of companies reap the benefits of lower cost labor, but long term, a nation of college-educated professionals turned fast-food employees is not a high-growth market.

Sustainable money is made by producing things: Manufacturing, product development, innovation… America needs to get back to making things. Not paying coolie labor in far away lands to make things that increasingly fewer people have the spending power to afford.